How Will Elections Affect the British Pound?

UK Prime Minister Gordon Brown announced on April 6 that the next general election will be held on May 6. Although the severe selloff (over -30%) from November 2007 ended in March 2009, the rebound of the pound was fragile and a new round of selling appeared to have begun in recent months. Recovery, growth, and budget deficits are investors' major concerns. Changes are what all British people are looking for. Therefore, election of a new government gives the market and the citizens a beam of hope.

However, uncertainty created by the election increases concerns. Recent polls of a highly likely hung parliament raised worries that the policy to solve the deficit problem will be delayed. This will threaten the country's AAA credit rating.

In our opinion, valuation of the pound is currently undervalued as the market has placed too much emphasis on a hung parliament and the drawbacks it will bring to the economy. While the bad news has been priced in, potential positive changes to the economy have largely been ignored.

How Does UK's Election System Work?

There are 650 constituencies in the UK. In a general election, normally held every four to five years, a member of Parliament (MP) is elected for each constituency from a list of candidates standing for election. The candidate who gets the most votes becomes the MP for that area until the next election.

Nearly all MPs represent political parties. The party with the most MPs after a general election usually forms the government. The next largest party becomes the official opposition party. If an MP does not have a political party, they are known as an “independent.” Since World War II, all the governments in the UK have been formed by either the Labour Party or the Conservative Party. In the upcoming election, a single party needs to get 326 seats to have an overall majority.

The general election for the House of Commons currently uses the first-past-the-post (FPTP) system, which is a plurality system with 650 separate constituencies, each electing a single member of Parliament. Winning candidates simply need to gain more votes than any other candidate; this need not be an absolute majority of all the votes cast in a constituency.

A Look Inside Different Deficit-Reduction Plans

As the UK is bearing the second biggest budget deficit in the developed world, deficit consolidation plans have become the focus of the debate.

Striving to secure economic recovery, the Labour Party said “it would be a huge mistake to cut support while the economy is still recovering.” However, it also promised to reduce the deficit, more than halving it over four years, as the recovery strengthens. “Reducing the deficit will come from a combination of tax, public spending cuts, and economic growth. We will act fairly, so that those who are most able to bear the burden make the greatest contribution. That means tax increases for those who can afford them, with a new 50p top rate for those who earn over £150,000 (the top 1% of earners). For people with incomes over £100,000 a year (the top 2% of earners), we will gradually remove their personal tax-free allowances. Tax relief on pensions will be restricted from next year, but again only for those with incomes above £130,000 a year. Looking across all the tax rises since the beginning of the global crisis, 60% of them will be paid for by the top 5% of earners. Spending will be tighter in the years ahead. We will protect schools, the NHS, and the police at the front line, but we will cut costs, inefficiencies, unnecessary programs, and lower-priority budgets. At all times, we will be guided by our values: Prioritizing families and businesses in the mainstream middle, and the public services which they rely on.”

The Conservative Party clearly takes a more aggressive approach in reducing the deficit and declared that it will deal with the deficit more quickly than Labour. Conservatives believe urgent action is needed so as to avoid the higher borrowing costs that would inevitably follow from a credit rating downgrade. The party promised to “Provide an emergency budget within 50 days of taking office to set out a credible plan for eliminating the bulk of the structural current budget deficit over a Parliament. The case for starting early to re-establish economic credibility is overwhelming, and is backed by economists and business leaders.”

Over the course of a Parliament, the party will cut Whitehall policy, funding, and regulation costs by a third, saving £2 billion a year, and save a further £1 billion a year from quango bureaucracy.

Concerning the Liberal Democratic Party's plan, it's milder than the Conservative Party plan, but also views tightening as being needed as soon as the economy permits it. The party believes the conditions will be right for cuts from 2011-2012, but not before. Liberal Dems have identified over £15 billion of savings in government spending per year, vastly in excess of the £5 billion per year that has been set aside for additional spending commitments. All spending commitments will be “Funded from this pool of identified savings, with all remaining savings used to reduce the deficit.”

NEXT: What if Election Results in a Hung Parliament?

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Implications from Opinion Polls: A Hung Parliament

The opposition Conservative Party has been consistently leading the Labour Party in opinion polls since late 2007. However, recent data show that the lead has been narrowing to mid- to low- single digits from over 10% a few months ago. Labour’s share of the vote has been rising as the UK economy improves and both consumer and business confidence soars. As the country's economy should move gradually in an uptrend, further increase in the Labour share is foreseeable.

Another issue is that the Liberal Democrats’ (Lib Dems) share has been surging of late. On April 16, YouGov poll for the Sun showed a huge surge for the Lib Dems, putting the party ahead of Labour and into second place after the leaders' debate on April 15. The top-line figures are: Conservatives, 33%(-4); Labour, 28%(-3); Liberal Democrats, 30%(+8). The surge in Lib Dem share appeared to have come evenly at the expense of the Conservatives and Labour. On April 17, a BPIX poll even puts the Liberal Democrats up in first place with top-line figures of: Conservatives, 31%(-7); Labour, 28%(-3); Liberal Democrats, 32% (+12), while YouGov's poll showed Labour regained the second place and Conservatives remained the first.

Although voting intentions do not guarantee the outcome and it's hard to translate the share of the vote won into seats won in the first-past-the-post system, results from many polls suggest the opposition Conservative Party will gain most seats without the majority, resulting in a hung parliament.

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Hung Parliament represents the situation where no single political party has a majority of MPs in the House of Commons. If this happens, two or more parties may decide that they have enough in common to form a coalition government. Alternatively, another general election may be held in the hope that it delivers a more decisive result.
Market worries about a hung parliament hinge on doubts on the efficiency of the ensuing government to implement policies to set the fiscal deficit issue back to normal. Conventional belief is that it may take longer for a hung parliament to pass legislations as it takes more time for consultations and negotiations. Moreover, MPs will need to spend more time at Westminster, thus potentially affecting the time they spend in their local constituency.

In UK history, the last hung parliament was dated back to 1974. After the election in February 1974, the Labour Party got the most seats, but failed to win an overall majority. The Conservative Prime Minister, Edward Heath, remained in office but eventually resigned a few days later as he failed to reach a coalition deal with the Liberal Party. Another election was held in October that year, resulting in the Labour Party taking an overall majority.

NEXT: Election's Potential Impact on GBP

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Implications for GBP

Recent performance of GBP has been closely tracking polling results, rising when polls show a clear majority government and falling when the lead narrows. The market has put very high emphasis on a hung parliament, which creates uncertainty that hurts the pound. In our opinion, the pound will continue to fluctuate with high volatility in coming weeks as the election approaches.

It's reasonable for investors to worry about a hung parliament in the UK as the last time it happened was more than 30 years ago. While it's unusual in the UK, the situation is common in many legislatures such as Germany, Ireland, Italy, and Canada.

Take Canada as an example. Although the country termed is as a “minority government,” the current Parliament (the 40th) is a hung parliament, as were the 38th and 39th Parliaments. The chart below shows that Canadian dollar has remained strong against the USD during the period of 2004 to 2010. Apparently, the Canadian currency has not been affected by the hung parliament.

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Several months ahead of both the 1974 election (election resulted in a hung parliament) and the 1992 election (opinion polls showing a hung parliament, but turned out to be untrue), the pound declined. We find the pattern quite similar to what we have experienced over the past months.

Shortly after election day, February 28, 1974, the pound fell for two days, then rebound and rallied almost +7% over the coming two months. In the 1992 election, the Conservative Party, contrary to a Labour victory according to polls, won for the fourth consecutive time. The pound surged immediately and the uptrend continued until September 1992.

If there's any correlation between the 1972 and 1974 elections and the present one, it's possible for the pound to continue rising against the dollar and other major currencies for several months after the election.

The pound should be volatile and driven by pre-election poll results and various debates before the election. However, volatility should be extremely high a week before the election.

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Assume the actual election outcome matches with what opinion polls suggest, and the Conservative Party wins without absolute majority. The pound will then be under pressure in the immediate aftermath of the election amid worries over a delay of deficit reduction. As all three parties have committed to deal with deficits, albeit less aggressively than the Conservatives, the pound will regain support when the parties (from the coalition government or the minority government) assure that they will solve the problems as soon as possible.